Mock sample exam CFA level III mock exam itemset answers 2013

2013 Level III Mock Exam
The 2013 Level III Chartered Financial Analyst (CFA®) Mock Examination has 60 questions. To best
simulate the exam day experience, candidates are advised to allocate an average of 18 minutes per item
set (vignette and 6 multiple choice questions) for a total of 180 minutes (3 hours) for this session of the
exam.

Questions

Topic

1–12

Ethical and Professional Standards

13-18

Risk Management

19-24

Equity Portfolio Management

25-30

Performance Attribution

31-36

Fixed Income Portfolio Management

37-48

Risk Management Applications of Derivatives

49-54

Portfolio Management of Global Bonds

55 -60

Global Investment Performance Standards

Total:

180


Questions 1 to 12 relate to Ethical and Professional Standards
Sue Kim Case Scenario
Sue Kim, CFA, is a hedge fund manager who specializes in biotechnology stocks. Kim has spent many
years investing in biotech companies and in the past, worked as an equity portfolio manager for a large
bank with substantial research capabilities. Two years ago, Kim started a hedge fund, Green Note
Investments. She manages accounts for several wealthy individuals. Now that she no longer has the
resources of the bank to support her research, Kim relies on a network of experts to help her search for
profitable investment opportunities in the biotechnology area. These experts include legal, business,
and political contacts.
Kim purchases information from several biotechnology company employees, none of whom are officers
of their respective companies, who perform work outside their regular positions as biotechnology
consultants or experts. These consultants work with Kim without the knowledge of their employers,
none of which has a prohibition on outside employment, and provide her with information about
quarterly earnings and other confidential data related to their companies’ performance. Kim bases her

final investment decision on this information and encourages the consultants and experts she works
with to publicly disclose the information that has been passed on to her.
In order to spread the news about the positive returns Green Note has achieved, Kim hires a public
relations consultant, Takehiko Akagi, CFA. Akagi tells Kim that for a marketing campaign to be effective,
she needs a five-year return history. Kim tries to retrieve her performance history from the bank but is
denied this request. Searching her home laptop computer, Kim finds her historical bank performance
data. Kim uses this bank data to recreate the first two years of the requested five-year performance
history. For the third year she simulates her investment performance by applying Green Note’s current
investment strategy to historical data, which she discloses in a footnote along with information about
whether the performance is gross or net of fees. For the final two years, Kim uses the actual
performance history of Green Note.
Because the marketing campaign takes longer than expected to accomplish its goal of bringing new
clients to the fund, Kim asks Akagi to accept a revised fee arrangement. Instead of paying Akagi a
monthly fee of $10,000 for his services marketing the fund, Kim proposes an investment management
fee sharing arrangement. For each client Akagi brings to Kim and whom she signs on as an investor in
Green Note, Kim will pay Akagi a fee of 10% of the investment management fee she charges that client
for his first 24 months in the fund. Akagi agrees to this arrangement, and Kim makes sure to disclose this
to prospective clients by verbally telling them that Green Note compensates Akagi for his efforts to find
investors for the fund, which is the first time clients are made aware of this arrangement. Akagi also
discloses to each client the fee he expects to earn from this arrangement once an investment
management agreement is signed.
Kim’s former university roommate, Donna Miriam, is now a legal expert in mergers and acquisitions.
Miriam has a number of connections to senior associates who specialize in this area of law at large, wellknown law firms. Miriam updates Kim when she hears a deal is about to be completed. Kim uses this
information as part of a mosaic of information she gathers from her own research and information from
other experts in her network. Once Kim has determined Miriam’s information is likely to be correct, Kim


trades derivative securities of the acquisition target. In the past 18 months, her merger and acquisition
investments have resulted in profits of $10 million for the hedge fund. Kim also manages a separate
account for Miriam, who has authorized Kim to replicate the trades in the acquisition targets for her

account. Because Miriam provides this valuable information, Kim makes sure she trades Miriam’s
account before any other client trades.
Julian Huang, a government lobbyist, is another key member of Kim’s expert network. Huang keeps in
constant contact with the many lobbyists involved in biotechnology issues and has close relations with
many legislators. Recently, legislators proposed restricting biotechnology research. If the legislation had
passed, it would have reduced valuations across the board for biotech stocks. Kim led the hedge fund
industry’s efforts to fight this change. She personally donated a large sum of money to support these
efforts and was also very successful in raising funds from the hedge fund community to fight the passing
of this proposed legislation.
Kim’s efforts to grow her fund result in new clients and rapid growth of assets under management.
Faced with a significant increase in her workload, Kim realizes she needs to change her investment
process to meet these new demands. In order to bring specialized experience to her investment
decision-making process, Kim hires several competent outside advisers to sit on her investment
committee, using her standardized criteria for adviser selection. Kim also subscribes to several wellknown third-party research vendors not considered previously because of their high expense. With
increased fees earned from additional assets under management, Kim can now afford to request
information from these vendors that is tailored to her specific needs. Because this research is so
specialized and detailed, and because Kim is confident that the outside advisers use diligence and a
reasonable basis in their research, she is able to use the reports, with a few minor changes, as her own.
Other than showing off her new reports, Kim does not tell clients of the changes made to her
investment process and reports.

1. By Kim executing trades based on the information she receives from the biotechnology
consultants employees, she least likely violates the CFA Institute Standards of Professional
Conduct concerning:
A. Market Manipulation.
B. Diligence and Reasonable Basis.
C. Material Nonpublic Information.
Answer = A
Guidance for Standards I-VII, CFA Institute
2013 Modular Level III, Vol. 1, Standard II (A) Material Nonpublic Information, Guidance,

Standard II (B), Market Manipulation, Guidance, Standard V (A) Diligence and Reasonable Basis,
Guidance
Study Session 1–2–b
Recommend practices and procedures designed to prevent violations of the Code of Ethics and
Standards of Professional Conduct.


A is correct because the hedge fund manager’s trades do not represent a violation of Standard II
(B), Market Manipulation. Kim is not engaging in practices that distort prices or artificially
inflates trading volume with the intent to mislead market participants. Because the trades are
based on material nonpublic information, however, Kim is in violation of Standard II (A) Material
Nonpublic Information. Kim is also in violation of Standard V (A) Diligence and Reasonable Basis
because she has based her investment decisions on information received from third parties and
has not determined if this information is sound and the processes and procedures used by those
responsible for the research were valid.

2. With regard to Green Notes’s five-year investment performance history, Kim is inconsistent
with the CFA Institute Standards of Professional Conduct concerning which of the following?
A. Performance as a hedge fund manager
B. Simulated performance of current strategy
C. Performance when she was an equity portfolio manager
Answer = C
Guidance for Standards I-VII, CFA Institute
2013 Modular Level III, Vol. 1, Standard III (D) Performance Presentation, Guidance, Standard IV
(A) Loyalty, Guidance
Study Session 1–2–a
Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional
Conduct by interpreting the Code and Standards in various situations involving issues of
professional integrity.
C is correct because showing past performance of funds managed at a prior firm as part of a

performance track record is permissible under Standard III (D) Performance Presentation only as
long as showing that record is accompanied by appropriate disclosures about where the
performance took place and the person’s specific role in achieving that performance, which Kim
did not do. In addition, the material used to create this performance record is the property of
Kim’s former employer, and in order to use this record she should have obtained permission to
do so but did not as required by Standard IV (A) Loyalty.

3. With regard to Kim’s fee arrangements with Akagi, whose actions are inconsistent with the
CFA Institute Standards of Professional Conduct?
A. Kim’s
B. Akagi’s
C. Both Kim and Akagi’s
Answer = C
Guidance for Standards I-VII, CFA Institute
2013 Modular Level III, Vol. 1, Standard IV (C) Responsibilities of Supervisors, Guidance,
Standard VI (C), Referral Fees, Guidance


Study Session 1–2–a
Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional
Conduct by interpreting the Code and Standards in various situations involving issues of
professional integrity.
C is correct because disclosure that fully explains the referral fee arrangement has not been
properly provided in violation of Standard VI (C) Referral Fees. Akagi is required to disclose in
writing, and prior to the execution of any agreement, referral fee agreements in place including
the nature and the value of the benefit. Kim is also in violation of Standard IV (C) Responsibilities
of Supervisors because she has a responsibility to oversee Akagi and ensure the appropriate
disclosures are made concerning referral fees. In addition, Kim verbally telling clients that Green
Note compensates Akagi for his efforts to find investors for the fund is not sufficient to meet the
disclosure requirements.

4. Kim’s relationship with Miriam is inconsistent with the CFA Institute Standards of
Professional Conduct concerning:
A. Fair Dealing.
B. Priority of Transaction.
C. Material Nonpublic Information.
Answer = B
Guidance for Standards I-VII, CFA Institute
2013 Modular Level III, Vol. 1, Standard II (A) Material Nonpublic Information, Guidance,
Standard III (B) Fair Dealing, Guidance, Standard VI (B) Priority of Transactions, Guidance
Study Session 1–2–a
Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional
Conduct by interpreting the Code and Standards in various situations involving issues of
professional integrity.
B is correct because Standard VI (B) Priority of Transactions concerns investment transactions
for clients and employers having priority over investment transactions in which a member or
candidate is the beneficial owner. Because the manager does not have beneficial ownership in
securities traded in client accounts, this Standard has not been violated. By purchasing shares
for Miriam’s account before other client accounts, the manager has violated Standard III (B) Fair
Dealing, which requires members and candidates to treat all clients fairly when taking
investment action with regard to general purchases. In addition, because the hedge fund
manager’s trades are based on material nonpublic information, they are in violation of Standard
II (A) Material Nonpublic Information. The mosaic theory is not applicable here because the
manager used it as a way to hide her receipt of material nonpublic information.

5. With regard to biotech legislation lobbying, is Kim consistent with the CFA Institute
Standards of Professional Conduct?
A. Yes

B. No, because of her efforts to influence legislation
C. No, because she mixed personal and hedge fund donations
Answer = A
Guidance for Standards I-VII, CFA Institute
2013 Modular Level III, Vol. 1, Code of Ethics, Standard I (A) Knowledge of the Law, Guidance
Study Session 1–2–b
Recommend practices and procedures designed to prevent violations of the Code of Ethics and
Standards of Professional Conduct.
A is correct because Kim has not violated the Code of Ethics and Standard I (A) Knowledge of the
Law. Her efforts to influence the legislative process, including her personal donations, are legal
and not a violation of any standard.

6. Which of Kim’s changes made as a result of having more assets under management is
consistent with the CFA Institute Standards of Professional Conduct?
A. Use of outside advisors
B. Client communications
C. Use of third-party research
Answer = A
Guidance for Standards I-VII, CFA Institute
2013 Modular Level III, Vol. 1, Standard I (C) Misrepresentation, Guidance,
Standard V (A) Diligence and Reasonable Basis, Guidance, Standard V (B) Communication with
Clients and Prospective Clients, Guidance
Study Session 1–2–b
Recommend practices and procedures designed to prevent violations of the Code of Ethics and
Standards of Professional Conduct.
A is correct because Standard V (A) Diligence and a Reasonable Basis requires members and
candidates to ensure their firms have standardized criteria for reviewing external advisers,
which Kim has met. Kim is in violation of Standard V (B) Communication with Clients and
Prospective Clients because she has not communicated the changes in her investment process
to clients. By presenting the third-party research as her own, Kim has also violated Standard I (C)

Misrepresentation.

Athena Case Scenario
Caitlyn Wilson, CFA, recently started her own asset management company, Athena Investment Services
(Athena). The board of directors of Athena has adopted both the CFA Code of Ethics and Standards of
Practice and the CFA Institute Asset Manager Code to institutionalize ethical behavior within the firm.
The board also implemented half-yearly staff performance reviews, including an assessment of each
manager’s ability to ensure his department’s compliance with the Code.


Six months into the first financial year, Wilson meets with all of her managers to assess each
department’s compliance. Wilson asks her compliance officer, Mark Zefferman, CFA, to make an
opening statement to set the right tone for the meeting. Zefferman states, “At a minimum, we are
responsible for implementing procedures addressing the general principles embedded in the six
components of the Code: As stated below, we must:
Statement 1:
Statement 2:
Statement 3:

Act with skill, competence and diligence while exhibiting independence and objectivity
when giving investment advice;
Put our clients’ interests above the firm’s when appropriate and act in a professional
and ethical manner at all times; and
Communicate with our clients in a timely and non-misleading manner and obey all rules
governing capital markets.”

Zefferman adds, “With regard to the last statement, please be aware we must implement the new AntiMoney Laundering Regulations being introduced by our local regulator with effect from the first quarter
of next year. I’ve done an analysis of the new regulations and have found that all of the local
requirements are part of new regulations recently introduced in Europe, where only a few of our clients
reside. When we start taking on new clients based in Singapore in the second half of next year, we will

also need to follow that country’s anti-money laundering regulations. The local anti-money laundering
legislation appears to be embedded in the Singapore regulations as well.”
Wilson states, “I would like each of you to explain how the implementation of the Asset Manager Code
within your department is being supervised. Let’s start with Shenal Mehta, our client service manager.”
Mehta states, “With respect to the Asset Manager Code relating to client services, we have ensured we
enforce the following policies: All disclosures are accurate and complete, and our calculations are
shown, no matter how complicated. We also ensure the client sees some sort of communication from us
when they request it and that the marketing material sent to clients is checked by the compliance
department for accuracy and completeness.”
Anders Peterson, CFA, chief investment officer, states, “In addition to what Mehta has said, I have the
following comments:
Comment 1:
Any communication with clients is kept confidential and is only accessible by authorized
personnel;
Comment 2: On occasion, we are able to acquire securities we expect will be particularly strong
performers, such as oversubscribed initial public offerings. In order to assure that all
clients are treated fairly, each client portfolio is given the same number of shares; and
Comment 3: A gift and entertainment policy is in place to help ensure that our managers and analysts
keep their independence and objectivity.”
Richard Gilchrist, head of portfolio administration, then adds, “Our portfolio policies call for all assets to
be valued at fair market prices using third-party pricing services. When a security price is not available
from the service, a committee whose members have experience in valuing illiquid assets uses the
hierarchy dictated by GIPS to determine values.”
Wilson concludes the meeting by mentioning that Athena must do even more to ensure its clients
continue to have faith in Athena’s ability to protect and grow their assets. She recommends they


disclose their risk management practices, which identify, measure, and manage the various risk aspects
of the business to clients and the regulator. She adds, “In addition, we need to create a business
continuity plan covering data backup and recovery, alternate trading systems if the primary system fails,

and methods to communicate to employees, critical vendors, and suppliers in case of an emergency that
could disrupt normal business functions.”

7. Which of Zefferman’s opening statements is inconsistent with the Asset Manager Code of
Professional Conduct?
A. Statement 1
B. Statement 2
C. Statement 3
Answer = B
“Asset Manager Code of Professional Conduct,” Kurt Schacht, Jonathan J. Stokes, and Glenn
Daggett
2013 Modular Level III, Vol. 1, Reading 6, General Principles of Conduct
Study Session 2–6–a
Explain the ethical and professional responsibilities required by the six components of the Asset
Manager Code.
B is correct because Zefferman states the firm is responsible for putting clients’ interests above
the firm’s when appropriate. The General Principles of Conduct embedded in the six
components of the Asset Manager Code state that managers have the responsibility of acting
for the benefit of clients. The code does not stipulate that this responsibility is applicable only
when appropriate.

8. Which of the following anti-money-laundering laws must Athena currently comply with to
be consistent with the CFA Institute Standards of Professional Conduct?
A. Local
B. European
C. Singaporean
Answer = B
“Guidance for Standards I-VII,” CFA Institute2013 Modular Level III, Vol. 1, Reading 2
Section: Standard I (A) Knowledge of the Law
Study Session 1–2–c

Recommend practices and procedures designed to prevent violations of the Code of Ethics and
Standards of Professional Conduct.
B is correct because Zefferman, as a CFA charterholder, will be responsible for ensuring Athena
complies with the stricter anti-money laundering laws of Europe, where some of its clients
reside, as per Standard I (A) Knowledge of the Law. Europe’s new laws, which encompass and


exceed the local anti-money-laundering regulations, are already in place; therefore, these are
the regulations that must be currently followed.

9. Which of Mehta’s client service policies is consistent with the Asset Manager Code?
A. Types of disclosures
B. Communication timing
C. Marketing material reviews
Answer = C
“Asset Manager Code of Professional Conduct,” Kurt Schacht, Jonathan J. Stokes, and Glenn
Daggett
2012 Modular Level III, Vol. 1, Reading 6
Sections: A. Loyalty to Clients, D. Risk Management, Compliance and Support, and F. Disclosures
Study Session 2–6–b
Determine whether an asset manager’s practices and procedures are consistent with the Asset
Manager Code.
C is correct because Section D, Risk Management, Compliance and Support of the Asset
Manager Code states that portfolio information provided to clients should be reviewed by an
independent third party. The compliance department would be considered an independent
third party because compliance is not involved with compiling or presenting the information to
clients. According to Section F, Disclosures, disclosures should be truthful, accurate, complete,
and understandable. It is unlikely clients would easily understand complicated calculations.
Section F, Disclosures calls for communications with clients to be on an ongoing and timely
basis. Annual communication would not be considered timely.

10. Which of Peterson’s comments is inconsistent with the Asset Manager Code?
A. Comment 1
B. Comment 2
C. Comment 3
Answer = B
“Asset Manager Code of Professional Conduct,” Kurt Schacht, Jonathan J. Stokes, and Glenn
Daggett
2012 Modular Level III, Vol. 1, Reading 6
Sections: A. Loyalty to Clients, and D. Risk Management, Compliance and Support
Study Session 2–6–b
Determine whether an asset manager’s practices and procedures are consistent with the Asset
Manager Code.
B is correct because Section B(6)(b) requires clients to be treated equitably, not equally. Clients
have different investment objectives and risk tolerances, so treating clients equally would be
inconsistent with the Asset Manager Code.


11. Are Gilchrist’s comments regarding portfolio valuation consistent with the Asset Manager
Code?
A. Yes
B. No, with regard to third-party pricing services
C. No, with regard to the process used to price illiquid securities
Answer = A
“Asset Manager Code of Professional Conduct,” Kurt Schacht, Jonathan J. Stokes, and Glenn
Daggett
2012 Modular Level III, Vol. 1, Reading 6
Sections: E. Performance and Valuation, F. Disclosures
Study Session 2–6–b
Determine whether an asset manager’s practices and procedures are consistent with the Asset

Manager Code.
A is correct because Section E of the Asset Manager Code calls for the use of fair-market values
sourced by third parties when available, and when such are not available, the code calls for the
use of “good faith” methods to determine fair value. Athena’s policy appears consistent with
this requirement. In terms of client reporting, monthly valuation reports would be consistent
with the call for timely reporting.

12. Are Wilson’s closing remarks consistent with recommended practices and procedures
designed to prevent violations of the Asset Manager Code?
A. Yes
B. No, with regard to the business continuity plan
C. No, with regard to disclosure of the firm’s risk management process
Answer = B
“Asset Manager Code of Professional Conduct,” Kurt Schacht, Jonathan J. Stokes, and Glenn
Daggett
2012 Modular Level III, Vol. 1, Reading 6, Appendix 6 - Recommendations and Guidance
Study Session 2–6–c
Recommend practices and procedures designed to prevent violations of the Asset Manager
Code.
B is correct because at minimum, Section D. Risk Management, Compliance and Support of the
Asset Manager Code recommends a business continuity plan to include plans for contacting and
communicating with clients during a period of extended disruption. Wilson’s continuity plan
includes no such strategy. Her recommendation for disclosing the firm’s risk management
process goes beyond the code recommendations to disclose the risk management process only
to clients, not to regulators. Wilson recommends they disclose to both.


Questions 13 to 18 relate to Risk Management
Laura Hackett Case Scenario
Laura Hackett is a risk management consultant who helps investment companies build and enhance

their risk management process. Jardins Advisors, a financial services firm with equity, fixed income, and
commodity trading desks, recently hired her to evaluate and recommend improvements to their
processes. Jardins’ senior management outlines their current risk management process to Hackett as
follows: “First, we establish policies and procedures for risk management. Next, we identify the types of
risk we face. We then measure our exposures to those risks. Finally, we determine our risk tolerance and
adjust levels of risk as appropriate.” They ask her, “Is this process appropriate?”
Alpha Asset Management Inc., another of Hackett’s clients, hired her to identify and separate its market
risk exposures into categories. Alpha was incorporated during the current year and focuses on one
investment strategy to generate returns. Alpha issues debt with a maturity of less than one year and
invests the proceeds in emerging market debt. Hackett creates a list of Alpha’s market risk categories.
Hackett asks Anthony Mackenzie, a recently hired associate, to apply the analytical method to estimate
the VAR for Alpha Asset Management’s portfolio, which is valued at $20 million. The portfolio has an
expected annual return of 7.5% and a standard deviation of 22.4%.
Another of Hackett’s clients is Beta Investment Advisors. Beta invests in a variety of asset classes and
international markets. It uses a historical simulation approach to measure the VAR of its portfolio, based
on the previous 24 months of market data. Beta asks Hackett to evaluate its approach relative to other
methods used for estimating portfolio VAR.
Sigma Investment Management Inc. is a potential new client that wishes to measure the credit risk of an
over-the-counter American call option on a security. The call option has a strike price of $65 and was
purchased at a price of $3.50 per option. The option’s current value is $8.50 per option.
In addition to measuring credit risk, Sigma asks Hackett to evaluate its over-the-counter derivative
positions and recommend ways to decrease credit risk associated with these positions. Sigma provides a
thorough explanation of its current process. At least 20 counterparties are used, each is limited to 7% of
Sigma’s total derivatives positions, and each must meet a minimum credit rating threshold. The
contracts have a typical term of two years, at which time they are marked to market and all payments
under the contract are netted and gains or losses settled.

13. What response would Hackett most likely make to Jardins Advisors’ senior management?
The firm should:
A. measure its risk levels before defining its risk tolerance.

B. define its risk tolerance before identifying the risks it faces.
C. identify the risks it faces before setting policies and procedures.


Answer = B
“Risk Management,” Don M. Chance, Kenneth Grant, and John Marsland
2013 Modular Level III, Vol. 5, Reading 34, Section 2
Study Session 14–34–a
Discuss the main features of the risk management process, risk governance, risk reduction, and
an enterprise risk management system.
B is correct because the risk management process is as follows: (1) set policies and procedures,
(2) define risk tolerance, (3) identify risks, (4) measure risks, and (5) adjust the level of risk.

14. Which of these risk categories is least likely to be on Hackett’s list for Alpha?
A. Political risk
B. Liquidity risk
C. Interest rate risk
Answer = A
“Risk Management,” Don M. Chance, Kenneth Grant, and John Marsland
2013 Modular Level III, Vol. 5, Reading 34, Section 4.1, Section 4.11
Study Session 14–34–d
Evaluate a company’s or a portfolio’s exposures to financial and nonfinancial risk factors.
A is correct because although the company is exposed to political risk via its investment in
emerging market debt, this risk is not a type of market risk. Market risks include risks associated
with interest rates, exchange rates, stock prices, and commodity prices.

15. Assuming normally distributed returns, the 5% yearly VAR for the Alpha Asset Management
portfolio is closest to:
A. $2,980,000.
B. $5,892,000.

C. $8,052,000.
Answer = B
“Risk Management,” Don M. Chance, Kenneth Grant, and John Marsland
2013 Modular Level III, Vol. 5, Reading 34, Section 5.2.2
Study Session 14–34–e
Calculate and interpret value at risk (VAR) and explain its role in measuring overall and individual
position market risk.
B is correct because there is a 5% chance the portfolio will lose 29.46%:
0.075 – (1.65 × 0.224) = 0.075 – 0.3696 = –0.2946;
hence the annual 5% VAR is


$20,000,000 × 0.2946 = $5,892,000.
With a standard normal distribution, 5% of possible outcomes are likely to be smaller than –1.65
times the standard deviation of the distribution.

16. Hackett’s description of Beta’s current approach to VAR estimation would most likely
mention that it:
A. is a nonparametric method of estimating VAR.
B. often assumes a daily portfolio expected return of zero.
C. produces a wide range of randomly generated potential outcomes.
Answer = A
“Risk Management,” Don M. Chance, Kenneth Grant, and John Marsland
2013 Modular Level III, Vol. 5, Reading 34, Section 5.2.3
Study Session 14–34–f
Compare the analytical (variance-covariance), historical, and Monte Carlo methods for
estimating VAR and discuss the advantages and disadvantages of each.
A is correct because the historical simulation approach to VAR measurement calculates what the
change in the current portfolio’s value would have been had it been held in the past, without
making any assumptions about the distribution of asset returns.

17. If the security held by Sigma Investment Management trades at $70, the credit risk is closest
to:
A. $3.35.
B. $5.00.
C. $8.50.
Answer = C
“Risk Management,” Don M. Chance, Kenneth Grant, and John Marsland
2013 Modular Level III, Vol. 5, Reading 34, Section 5.6.4
Study Session 14–34–i
Evaluate the credit risk of an investment position, including forward contract, swap, and option
positions.
C is correct because the amount at risk is the current value of the option, $8.50. Once the seller
has sold the option, all the credit risk falls on the buyer. In this instance, the amount of credit
risk is the value of the option because this amount is what the buyer stands to lose if the seller
were to default immediately.

18. Sigma can most likely reduce credit risk in its over-the-counter derivatives positions by
changing which of the following practices?


A. Netting
B. Limiting counterparty exposure
C. Frequency of marking-to-market
Answer = C
“Risk Management,” Don M. Chance, Kenneth Grant, and John Marsland
2013 Modular Level III, Vol. 5, Reading 34, Section 6.2
Study Session 14–34–k
Demonstrate the use of exposure limits, marking to market, collateral, netting arrangements,
credit standards, and credit derivatives to manage credit risk.

C is correct because Sigma typically enters two-year contracts and does not mark to market until
expiration of the contract. Increasing the frequency of the marking to market will decrease
credit risk. When a contract is marked to market, the party to whom the contract has a positive
value receives payment from the counterparty, thus eliminating credit risk. Consequently, more
frequent marking to market decreases credit risk.

Questions 19 to 24 relate to Equity Portfolio Management
Sonera Endowment Fund Case Scenario
William Gatchell, CFA, is an investment analyst with the Sonera Endowment Fund. Sonera is considering
hiring a new equity investment manager. In preparation, Gatchell meets with Anjou Lafite, another
analyst at the fund, to review a relevant part of the endowment’s investment policy statement:
“Funds will be invested in the most efficient vehicle that meets the investment objective. Each manager
must demonstrate the efficiency with which the tracking error they take on delivers active return. In
addition, each manager must consistently adhere to his stated style.”
Gatchell is given the task of reviewing three investment managers and selecting a manager that is most
likely to adhere to Sonera’s investment policy statement. Information about the investment managers is
found in Exhibit 1.
Exhibit 1
Investment Manager Data

Assets under management ($ millions)
Information ratio
Small-cap value index– beta
Small-cap growth index– beta
Large-cap value index – beta
Large-cap growth index – beta

A
1,325
–0.27

0.95
0.32
1.05
0.47

Investment Manager
B
3,912
0.50
0.98
0.43
1.10
0.39

C
524
0.75
1.05
0.48
0.96
0.37


Manager stated style
Manager stated sub-style

Value
Low P/E

Value

High yield

Growth
Momentum

Gatchell is reviewing the fee structures proposed by the three investment managers. He finds the
following reference in the investment policy statement:
“The fee structure must be easy to understand and avoid undue complexity wherever possible. Also, the
fee structure must be predictable, so Sonera can reasonably forecast these costs on a yearly basis as an
input to the annual budgeting process.”
He understands there are many different fee structures, and he wants to make sure he chooses the
most appropriate one for the Sonera Endowment Fund. He prepares a recommendation to the
investment policy committee regarding the most appropriate fee structure.
Sonera has followed an active investment style for many years. Gatchell would like to recommend to the
investment policy committee that a portion of the funds be invested using a passive investment style.
His research shows there are a number of methods used to weight the stocks in an index, each having its
own characteristics. The one key feature he feels is important is that the method chosen not be biased
towards small-capitalization stocks.
Gatchell is also examining different ways to establish passive equity exposure. He states to Lafite, “There
are a number of ways to get passive equity exposure; we can invest in an equity index mutual fund, a
stock index futures contract, or a total return equity swap. Stock index futures and equity swaps are
low-cost alternatives to equity index mutual funds; however, a drawback of stock index futures is they
have to be rolled over periodically. One advantage of investing in equity mutual funds is that shares can
be redeemed at any point during the trading day.”
Gatchell is reviewing the performance of another investment manager, Far North, which employs a
value-oriented approach and specializes in the Canadian market. Gatchell would like to recommend to
the investment policy committee that the fund diversify geographically. The information for Far North
and the related returns are found in Exhibit 2.
Exhibit 2
Far North: Return Information

Rate of Return
Far North
14%
True active return
–1%
Misfit active return
5%
The investment policy committee reviews the information in Exhibit 2 and is not familiar with the terms
true active return and misfit active return. Gatchell responds with the following statement:
“The true active return is the return Far North made above its normal benchmark return. The misfit
active return is the return Far North made above the investor’s benchmark return. The term investor’s
benchmark refers to the benchmark the investor uses to evaluate performance for a given portfolio or
asset class.”


19. Based on Exhibit 1, which investment manager most likely meets the criteria established in
the endowment’s investment policy statement?
A.
B.
C.

Manager A
Manager B
Manager C

Answer = B
“Equity Portfolio Management,” Gary L. Gastineau, Andrew R. Olma, and Robert G. Zielinski
2013 Modular Level III, Vol. 4, Reading 27, Section 3, 5.1.4
Study Session 11–27–b,c
Discuss the rationales for passive, active, and semiactive (enhanced index) equity investment

approaches and distinguish among those approaches with respect to expected active return and
tracking risk.
Recommend an equity investment approach when given an investor’s investment policy
statement and beliefs concerning market efficiency.
B is correct because manager B has a positive information ratio, demonstrating that he has been
able to deliver active returns relative to his level of tracking error. Manager B’s investment style
is consistent with a value investment style, with a higher beta for the two value indices, the
small-cap value index and the large-cap value index.

20. Based on Exhibit 1, is there sufficient information for Gatchell to create and interpret the
results of a style box?
A. Yes
B. No, because additional index data are required
C. No, because additional holdings data are required
Answer = C
“Equity Portfolio Management,” Gary L. Gastineau, Andrew R. Olma, and Robert G. Zielinski
2013 Modular Level III, Vol. 4, Reading 27, Section 5.1.5, 5.1.6
Study Session 11–27–j,k
Compare the methodologies used to construct equity style indices.
Interpret the results of an equity style box analysis and discuss the consequences of style drift.
C is correct because holdings data are required to create a style box and interpret the results.
Gatchell is given the styles and the assets under management but not each individual investment
or holding that each investment manager has selected.

21. Which fee structure is most appropriate for Sonera based on the criteria in the investment
policy statement?
A. An ad valorem fee structure


B. A performance-based fee structure with a fee cap

C. A performance-based fee structure with a high water mark
Answer = A
“Equity Portfolio Management,” Gary L. Gastineau, Andrew R. Olma, and Robert G. Zielinski
2013 Modular Level III, Vol. 4, Reading 27, Section 8.3
Study Session 11–27–u
Describe the process of identifying, selecting, and contracting with equity managers.
A is correct because ad valorem fee structures are both simple and predictable. The ad valorem
fee structure is calculated by multiplying the value of the assets by a percentage.

22. If the investment policy committee decides to accept Gatchell’s recommendation to also use
passive investing, the index structure that least likely meets Gatchell’s requirement is:
A. a price-weighted index.
B. a value-weighted index.
C. an equal-weighted index.
Answer = C
“Equity Portfolio Management,” Gary L. Gastineau, Andrew R. Olma, and Robert G. Zielinski
2013 Modular Level III, Vol. 4, Reading 27, Section 4.1.1
Study Session 11–27–d
Distinguish among the predominant weighting schemes used in the construction of major equity
share indices and evaluate the biases of each.
C is correct because an equal-weighted index is biased towards small-capitalization stocks.
23. In his statement to Lafite, Gatchell is least likely correct with respect to:
A. cost.
B. redemption.
C. periodic rollover.
Answer = B
“Equity Portfolio Management,” Gary L. Gastineau, Andrew R. Olma, and Robert G. Zielinski
2013 Modular Level III, Vol. 4, Reading 27, Section 4.2
Study Session 11–27–e
Compare alternative methods for establishing passive exposure to an equity market, including

indexed separate or pooled accounts, index mutual funds, exchange-traded funds, equity index
futures, and equity total return swaps.
B is correct. Gatchell is correct that stock index futures and equity swaps are low-cost
alternatives to equity index mutual funds. He is also correct that a drawback of stock index


futures is they have to be rolled over periodically. He is incorrect about the pricing of mutual
funds: They are priced once daily.
24. Is Gatchell’s statement regarding true active return and misfit active return correct?
A. Yes
B. No, he is incorrect about true active return
C. No, he is incorrect about misfit active return
Answer = C
“Equity Portfolio Management,” Gary L. Gastineau, Andrew R. Olma, and Robert G. Zielinski
2013 Modular Level III, Vol. 4, Reading 27, Section 7.1
Study Session 11–27–s
Distinguish among the components of total active return (“true” active return and “misfit”
active return) and their associated risk measures and explain their relevance for evaluating a
portfolio of managers.
C is correct because the definition of misfit active return is incorrect. Misfit active return is the
difference between the normal benchmark and the investor’s benchmark.

Questions 25 to 30 relate to Performance Attribution
Minglu Li Case Scenario
REDD Partners specializes in forecasting and consulting in particular sectors of the equity market. Minglu
Li is an analyst for REDD Partners who specializes in the consumer credit industry. Last year (2012), Li
and her team gathered data to determine the expected return for the industry (see Exhibit 1).
Exhibit 1
Returns and Premiums Data (2012)
Securities and Interest Rates

Expected Yield
10-year U.S. Treasury securities
Short-term real rate
Long-term real rate
10-year AA corporate bond yield
Type of Premium
Inflation premium
Illiquidity premium
Equity risk premium

3.8%
2.0%
2.3%
4.4%
Premium
0.6%
0.9%
8.4%

After considering a number of approaches, Li and her team decided to use the bond-yield-plus-riskpremium method. The method worked well in 2012, but a new assignment presented to Li’s team the
previous week posed a new challenge.


A new consumer credit mechanism was being tested on a small scale using a “smart phone” application
to pay for items instead of the traditional credit card. The application had proved successful in the use of
microloans in developing countries and was now being applied to a much broader consumer base. The
new challenge for Li’s team is to develop a model for the expected return for these new consumer credit
companies, called “smart credit” companies, that combine the consumer credit industry and what
traditionally was considered the telecommunications industry.
Although smart credit company returns data are sparse, a five-year monthly equally weighted index

called the Smart Credit Index (SCI) was created from the existing companies’ returns data. The number
of companies in the index at a given time varies as a result of firms failing and also combining through
time.
The SCI risk premium, equal to the SCI return less the risk-free rate, denoted as SCIRP, is used as the
dependent variable in a two-factor regression where the independent variables are index returns less
the risk-free rate for the consumer credit industry (CCIRP) and the telecommunications industry
(TELIRP). The regression results are in Exhibit 2.

Exhibit 2
Data, Statistics, and Regression Results
Index
Mean
Variance
SCIRP
5.4%
0.2704
CCIRP
4.6%
0.0784
TELIRP
2.8%
0.1024
Note: CCIRP and TELIRP are uncorrelated.
Regression Coefficient
α
β (CCIRP)
Coefficient Value:
0.011
1.020
Note: All coefficients are statistically significant at the 95% level.

β (TELIRP)
1.045

Although volatility information is available from the SCI data and correspondingly for the SCIRP, Li’s
team wants to determine the statistical relationship between the SCIRP and both the consumer credit
index risk premium (CCIRP) and the telecommunications index risk premium (TELIRP) because
forecasting the CCIRP and TELIRP is much less difficult than forecasting the SCIRP. After some discussion,
the team believes that the volatility measure for the SCIRP data based on the volatility of CCIRP and
TELIRP through the regression should be adjusted to incorporate a correlation coefficient of 0.25
between the CCIRP and TELIRP. Although the two index risk premiums were uncorrelated in the past and
within the regression, Li’s team believes the two technologies will become more correlated in the
future.
Li’s team also examined survey data within the consumer credit and telecommunications industries
during the same time period for which the actual data was collected. They found that projections in the
surveys of the CCI and TELI tended to be more volatile than the actual data. Li’s team has decided not to
make any adjustments, however, because a definitive procedure could not be determined.


Given the effect of short-term interest rates on consumer credit, Li’s team then decides to determine
where the short-term interest rate is expected to be in the future. The Central Bank recently issued a
statement that 2.5% appeared to be the appropriate rate assuming no other factors. Li’s team then
considers potential factors that may make the Central Bank behave differently from the 2.5% rate in the
statement (see Exhibit 3).
Exhibit 3
Central Bank Factors
GDP growth forecast
GDP growth trend
Inflation forecast
Inflation target

Earnings growth forecast
Earnings growth trend

2.0%
1.0%
1.5%
3.5%
4.0%
2.0%

Based on Taylor’s rule with an assumption of equal weights applied to forecast versus trend measures,
the short-term rate is expected to increase from the current 1.23% and the yield curve is expected to
flatten.
For further insight, Li decides to consult an in-house expert on central banking, Randy Tolliver. Tolliver
states that a flat yield curve is consistent with tight monetary and tight fiscal policies.

25. Based on Exhibit 1 and the method used by Li’s team, the expected return for the consumer
credit industry in 2012 was closest to:
A. 12.2%.
B. 12.8%
C. 13.7%.
Answer = A
“Capital Market Expectations,” John P. Calverley, Alan M. Meder, Brian D. Singer, and Renato
Staub
2013 Modular Level III, Vol. 3, Reading 18, Section 3.1.3.3
Study Session 6–18–c
Demonstrate the application of formal tools for setting capital market expectations, including
statistical tools, discounted cash flow models, the risk premium approach, and financial
equilibrium models.
A is correct. The bond-yield-plus-risk-premium method (Equation 8) sets the expected return to

the yield to maturity on a long-term government bond plus the equity risk premium (12.2% =
3.8% + 8.4%).

26. The SCI data most likely exhibits which type of bias?
A. Time period


B. Data mining
C. Survivorship
Answer = C
“Capital Market Expectations,” John P. Calverley, Alan M. Meder, Brian D. Singer, and Renato
Staub
2013 Modular Level III, Vol. 3, Reading 18, Section 2.2.2
Study Session 6–18–b
Discuss in relation to capital markets expectations, the limitations of economic data, data
measurement errors and biases, the limitations of historical estimates, ex post risk as a biased
measure of ex ante risk, biases in analysts’ methods, the failure to account for conditioning
information, the misinterpretation of correlations, psychological traps, and model uncertainty.
C is correct. The SCI data is an index that is not composed of the same number of firms in each
period because of firm failures and combinations through time, which indicates survivorship
bias.

27. Based on the correlation that Li’s team believes to exist between the CCIRP and TELIRP, the
new volatility for the SCIRP is closest to:
A. 31.8%.
B. 49.1%.
C. 56.4%.
Answer = C
“Capital Market Expectations,” John P. Calverley, Alan M. Meder, Brian D. Singer, and Renato
Staub

2013 Modular Level III, Vol. 3, Reading 18, Section 3.1.1.4
Study Session 6–18–c
Demonstrate the application of formal tools for setting capital market expectations, including
statistical tools, discounted cash flow models, the risk premium approach, and financial
equilibrium models.
C is correct. Based on Equation (3a) applied to a regression:
( )
( )
( )

( )

( )

( )

(

)

Find the variance of the error term using values from Exhibit 2:
(
( )

)

(

)

( )


The adjustment is a correlation of 0.25.
Change the correlation into a covariance:
(

)

(

)

( )

(

)

( )

(

)

Apply the new covariance to Equation (3a) to find the new variance:
(

)

The volatility of SCI after adjusting for the correlation is 56.4% = √

(

)

.

28. A comparison between the survey data containing projections of the CCI and TELI and the
actual CCI and TELI most likely exhibits:
A. a status quo trap.
B. a recallability trap.
C. ex post risk being a biased measure of ex ante risk.
Answer = C
“Capital Market Expectations,” John P. Calverley, Alan M. Meder, Brian D. Singer, and Renato
Staub
2013 Modular Level III, Vol. 3, Reading 18, Section 2.2.4
Study Session 6–18–b, d
Discuss in relation to capital markets expectations, the limitations of economic data, data
measurement errors and biases, the limitations of historical estimates, ex post risk as a biased
measure of ex ante risk, biases in analysts’ methods, the failure to account for conditioning
information, the misinterpretation of correlations, psychological traps, and model uncertainty.
Explain the use of survey and panel methods and judgment in setting capital markets
expectations.
C is correct. As stated, the projections in the survey data tended to be more volatile than the
actual outcomes over the same time period. This finding indicates that the ex post risk (i.e., the
volatility of the actual data) tends to have a downward bias relative to the ex ante risk displayed
by the survey data. This result is evidence of ex post risk being a biased measure of ex ante risk.

29. Based on how the Taylor rule is applied by Li’s team, the Central Bank’s optimal short-term

rate is closest to:
A. 1.5%.
B. 2.0%.


C. 2.8%.
Answer = B
“Capital Market Expectations,” John P. Calverley, Alan M. Meder, Brian D. Singer, and Renato
Staub
2013 Modular Level III, Vol. 3, Reading 18, Section 4.1.5.3
Study Session 6–18–h
Demonstrate the use of the Taylor’s rule to predict central bank behavior.
B is correct.
The Taylor rule (Equation 12 p. 66) sets the optimal short-term rate as:
Neutral rate + 0.5 × (GDP growth forecast – GDP growth trend) + 0.5 × (Inflation forecast –
Inflation target)
Applying numbers from Exhibit 3,
(

)

(

).

30. Tolliver’s statement regarding the yield curve is most likely:
A. correct.
B. incorrect with regard to fiscal policy.
C. incorrect with regard to monetary policy.
Answer = B

“Capital Market Expectations,” John P. Calverley, Alan M. Meder, Brian D. Singer, and Renato
Staub
2013 Modular Level III, Vol. 3, Reading 18, Section 4.1.5.4
Study Session 6–18–i
Evaluate 1) the shape of the yield curve as an economic predictor and 2) the relationship
between the yield curve and fiscal and monetary policy.
B is correct. A flat yield curve is consistent with tight monetary policy and loose fiscal policy
making. Tolliver’s statement is incorrect in regard to fiscal policy.

Questions 31 to 36 relate to Fixed Income Portfolio Management
Franconia Notch Case Scenario
Mark Whitney, CFA, is the chief investment officer of Granite State Partners, a fixed income investment
boutique serving institutional pension funds. Paula Norris, a partner at consulting firm Franconia Notch


Associates, is conducting due diligence of Granite’s capabilities. At a meeting, they go over a
presentation Whitney has prepared.
The first page of the presentation addresses Granite’s investment style for managing portfolios. It states:
“Granite adjusts the portfolio’s duration slightly from the benchmark, and attempts to increase relative
return by tilting the portfolios in terms of sector weights, varying the quality of issues, and anticipating
changes in term structure. The mismatches are expected to provide additional returns to cover
administrative and management costs.”
Norris asks Whitney about Granite’s ability to successfully reflect, in its portfolios, its views on the
market and the direction of interest rates. Whitney makes the following statements:
Statement 1:

“Granite uses effective duration to measure the sensitivity of the portfolio’s price to a
relatively small parallel shift in interest rates. For large parallel changes in interest rates,
we make a convexity adjustment to improve the accuracy of the estimated price
change. We believe that parallel shifts in the yield curve are relatively rare; therefore,

duration by itself is inadequate to capture the full effect of changes in interest rates.”

Statement 2:

“We address yield curve risk by using key rate durations. When using this method, we
stress the spot rates for all points along the yield curve simultaneously. By changing the
spot rates across maturities, we are able to measure a portfolio’s sensitivity to those
changes.”

Statement 3:

“We also measure spread duration contribution. This analysis is not related to interest
rate risk. This measure describes how securities such as corporate bonds or mortgages
will change in price as a result of the widening or narrowing of the spread to
Treasuries.”

Norris provides information on three clients he might refer to Whitney for portfolio management
services and asks him to design a dedication strategy for each. Whitney makes the following
recommendations:
Client 1:

“This bank has sold a five-year guaranteed investment contract that guarantees an
interest rate of 5.00% per year. I would purchase a bond with a target yield of 5.00%
maturing in five years. Regardless of the direction of rates, the guaranteed value is
achieved.”

Client 2:

The defined benefit pension plan for this client has an economic surplus of zero. In order
to meet the liabilities for this plan, I will construct the portfolio duration to be equal that

of the liabilities. In addition, I will have the portfolio payments be less dispersed in time
than the liabilities.

Client 3:

This client’s long-term medical benefits plan has known outflows over 10 years. Because
perfect matching is not possible, I propose a minimum immunization risk approach,
which is superior to the sophisticated linear program model used in the current cash
flow matching strategy.


Norris asks Whitney what steps he takes to takes to reestablish the dollar duration of a portfolio to the
desired level in an asset–liability matching (ALM) application. Whitney responds: “First, I calculate a new
dollar duration for the portfolio after moving forward in time and shifting the yield curve. Second, I
calculate the rebalancing ratio by dividing the original dollar duration by the new dollar duration and
subtracting 1 to get a percentage change. Third, I multiply the new market value of the portfolio by the
desired percentage change from step two”.
Norris then asks Whitney, “What sectors are you currently recommending for client portfolios”?
Whitney responds: “I recommend investing 25% of the portfolio in mortgage-backed securities because
they are trading at attractive valuations. I will not, however, buy floating-rate securities because these
do not hedge liabilities appropriately.”
Norris asks how changing market conditions lead to secondary market trading in Granite’s client
portfolios. Whitney responds: “Our research teams run models to assess relative value across fixed
income sectors which, combined with our economic outlook, leads to trade ideas. For example,
currently our macroeconomic team is concerned about the situations in several sovereign nations and
the spillover effect to capital markets. These issues range from geopolitical risks that will likely increase
the price of oil to outright sovereign defaults or restructuring.”

31. The style of investing described in Whitney’s presentation is most likely:
A. a full replication approach.

B. enhanced indexing by small risk factor mismatches.
C. active management by larger risk factor mismatches.
Answer = C
“Fixed-Income Portfolio Management – Part I,” H. Gifford Fong and Larry D. Guin
2013 Modular Level III, Vol. 4, Reading 23, Section 3.1
Study Session 9–23–b
Compare pure bond indexing, enhanced indexing, and active investing with respect to the
objectives, advantages, disadvantages, and management of each.
C is correct because Granite is not only tilting the portfolios with regard to certain sectors,
quality, or term structure as an enhanced indexer would, it is also making duration adjustments.
An indexer (full replication approach) or enhanced indexer would keep the duration matched to
the index.

32. Which of Whitney’s Statements with regard to implementing its market and interest rate
views is least likely correct?
A. Statement 1
B. Statement 2